The Swiss Franc Chaos Shows Why Negative Interest Rates Don't Work

A man falls off the
"gostra," a pole covered in grease, during the celebrations for
the religious feast of St. Julian, Aug. 31, 2014.REUTERS/Darrin Zammit
Lupi

Not long ago, a theory was floated that in order to avert an
economic crisis, all central banks had to do was cut interest
rates below zero and this would boost growth. That theory was
then put to the test in
the eurozone and
Switzerland. And now, it's failing.

In June 2014, the European Central Bank (ECB) decided to cut its
deposit rate (the interest rate that it pays on reserves held by
the central bank) to -0.10%. In September, this was
cut again to -0.20%.

The theory was that charging banks for holding money with
the central bank would force them to seek better returns
elsewhere, either through investing in productive assets in the
monetary union or transferring their money to safe assets
overseas.

In the first case, the additional productive investment
would help drive up growth directly, whereas in the second, the
capital outflows would help weaken the currency and make the
region's exports more competitive, also improving its growth
prospects.

So what happened?

Well, the investment channel didn't exactly deliver. Data
released in December showed Euro-area investment contracted for a
second consecutive quarter, falling 0.2% in the three months
to the end of September after a 0.6% fall over the previous
period.

But that was only one of the possible ways in which
negative rates might be expected to boost growth. As the theory
suggested, negative rates did have an effect on the currency,
helping to force the euro down. Here's how it performed against
the US dollar:

The euro's precipitous fall against other major currencies
did seem to have an effect. For example, Germany, Europe's
largest and strongest economy, has been able to maintain a
substantial trade surplus (meaning the value of exports has been
greater than the value of imports), despite the ongoing weakness
of some of its regional trading partners in Southern Europe as
well as slowing growth in major emerging markets including China
and Russia.

As far as the theory went, it seemed things were going
(roughly) according to plan. All that needed to happen now was to
wait for the growth to come through, and the eurozone crisis
would finally be over.

Except the growth prospects for the eurozone weren't
getting any better. In fact, they appeared to be getting worse.
Why? Well, much of the money being generated from this trade
appeared to be going back into foreign safe assets such as US
Treasury bonds or into local safe havens such as German
government debt.

This helped drive down the interest rates on that debt,
driving a large chunk of it into negative territory. That is,
investors have started paying the German government to hold their
money for them.

Yet instead of using this effectively free money to invest, the
German government has decided in its wisdom to squirrel the money
away, using it to run a budget surplus. In essence, Germany is
saying that it can't find any major projects in the whole of the
monetary union where it is likely to get a return greater than
zero. Hardly a ringing endorsement of the region's prospects.

Meanwhile, much of Southern Europe is being forced to try to run
budget surpluses in order to put government-debt dynamics back
onto a sustainable path — and so have little scope to invest
themselves.

Although the positive aspects of negative rates failed to
materialize, the negative spillover effects are certainly in
evidence. The money flooding out of the eurozone needed a new
home and much of it ended up moving into Switzerland, helping to
drive up the value of the Swiss franc against the euro.

Why the Swiss central bank removed its CHF peg: Inflows had
just begun once again, after stopping in 2012. pic.twitter.com/EdLXbqUXBD

This poses big problems for the Swiss central bank.
As Swiss leaders said in 2011 when they imposed a cap for how
much the Swiss National Bank (SNB) would allow the currency to
appreciate against the euro, "The current massive overvaluation of the
Swiss franc poses an acute threat to the Swiss economy and
carries the risk of a deflationary development."

Interestingly, the SNB also imposed negative interest rates on
deposits in December last year to -0.25% — though this time in an
effort to halt the pace of capital inflows into the country. In
other words, they were signaling that they would charge investors
even more than the ECB was prepared to for their safe-haven
status.

Now the SNB is attempting to offset the effects of abandoning the
currency cap, which was becoming prohibitively expensive for the
central bank to maintain. With market expectations of ECB
quantitative easing weakening the euro further, interest rates on
deposits plummeted even more, to a historic low of -0.75%. And
here's how that went — the currency still surged:

As long as there is a risk of further major shocks in the
eurozone, it will be extremely difficult to stem capital flows
into perceived safe havens such as Switzerland — indeed, they
might well increase from here. After all, what is losing 0.75% on
your Swiss franc savings compared with the erosion of your euro
purchasing power as the latter weakens?

The lesson here? Beware those advocating one easy answer to all
your problems. Negative rates are great in theory, but in the
messy reality of financial markets they can prove highly
disruptive and counterproductive. If it is going to
get itself out of its current mess, Europe will need
more coordination between the central bank and
governments.